PoC)icy RESEARCH WORKIN( I'APER 1543 The Combined Incidence In the Phiippines, the combined effect of taxation of Taxes and Publi c and spending policies is Expendittires in the progressive, because the L( X in tflC incidence pattern of spending ; Philippines is progressive while that of Philippines taxation is neutfal. Indirect taxes, the nrarrr source of Sbantayanan D)evarajan government revenue, are Shaikb I. 1Iossain G)nly slightly regressive Although the poor consume taxed goods such as energy directly, the rich consume them indirectly by purchasing goods Nwhose production requires energy and other taxed goous The World Bank l'olicy Research Departmenc. Piiblic Econiomics Division Noveimber 1995 POLICY RESEARCH WORKING PAPER 1543 Summary findings Incidence studies of fiscal policy in developing countries Philippines - can be estimated using a variety of data typically examine either the distribution of tax burdens sources and tools, using simplifying assumptions. or the incidence of public expenditures. But the central For 20 years, the Philippine economy has experienced a issue for policymakers is the combined or net incidence series of balance of payments crises triggered by fiscal of fiscal activities. crises. It has had an unsatisfactory record of poverty Even if a tax is regressive, the impact of increasing alleviation. As the government tries to maintain fiscal it may not be, if the revenue raised is spent in a discipline by raising taxes and cutting spending, how will progressive manner. But even if the beneficiaries of poverty be affected? Devarajan and Hossain examine net public spending are the poor, the net effect may not fiscal incidence to find out. Their findings: be pro-poor, if the spending is financed by a highly * The incidence pattern of taxes is basically neutral. regressive tax. Contrary to expectations, indirect taxes are only slightly One reason that combined incidence studies are so regressive. The poor consume taxed goods such as rare: they require detailed data on both taxation and energy directly, but the rich consume them indirectly by public spending. Most analysts consider themselves lucky purchasing goods the production of which requires if they have data on either. energy and other taxed goods. Devarajan and Hossain show that the net incidence of * It is the pattern of expenditures that drives the fiscal policy in a country with average data - the combined incidence, which is progressive. This paper - a product of the Public Economics Division, Policy Research Department - is a revised version of Chapter 15 of the World Bank report, "The Philippines: An Opening for Sustained Growth." Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Cynthia Bernardo, room N10-053, telephone 202-473-7699, fax 202-522-1154, Internet address prdpe@worldbank.org. November 1995. (26 pages) The Policy Research Working Paper Series disseminates the findings of Dork in progress to encourage the exchange of ideas about development issues. An ob7jective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be used and cited accordingly. The findings, interpretations, and conclusions are the authors' own and should not be attributed to the World Bank, its Executive Board of Directors, or any of its member countries. Produced by the Policy Research Dissemination Center THE COMBINED INCIDENCE OF TAXES AND PUBLIC EXPENDITURES IN THE PHILIPPINES Shantayanan Devarajan and Shaikh I. Hossain This is a revised version of Chapter 15 of World Bank Report No. 11061-PH, "The Philippines: An Opening for Sustained Growth." We are grateful to Homi Kharas, Farrukh Iqbal and Dominique van de Walle for helpful comments. THE COMBINED INCIDENCE OF TAXES AND PUBLIC EXPENDlTURES IN THE PHILIPPINES by Shantayanan Devarajan Shaikh I. Hossain I. Introduction Studies of the incidence of fiscal policy in developing countries typically examine either the distribution of tax burdens (e.g., Almad and Stern 1989, Shah and Whalley 1991), or the incidence of public expenditures (e.g., Meerman 1978, Selowsky 1979, van de Walle and Nead 1995 ). Yet the central issue for policymakers is the combined or net incidence of fiscal policy. For even if a tax is regressive, the overall impact of increasing it may not be, if the revenue raised is spent in a progressive manner. Conversely, while the beneficiaries of public spending may be the poor, if this spending is financed by a highly regressive tax, the net effect may not be pro-poor. One reason why combined fiscal incidence studies are so rare is that they require detailed data on both taxation and public expenditures. Most analysts consider themselves fortunate if they have data on either. The purpose of this paper is to show that the net incidence of fiscal policy in a country with average data -- the Philippines -- can be estimated using a variety of data sources and tools. Needless to say, we make numerous simplifying -- some would say heroic -- assumptions, draw on different data sources and put the available tools to creative use. Nevertheless, a fairly robust picture of the net incidence of taxes and expenditures in the Philippines emerges. Furthermore, the pattern of incidence that we find has important imnplications for Philippine economic policy. During the past 20 years, the Philippines has been characterized by a series of balance of payments crises, triggered by fiscal crises, and an unsatisfactory record of poverty alleviation. As the government attempts to maintain fiscal discipline by I raising taxes and cutting expenditures, how will poverty be affected? The answer lies in the net incidence of fiscal policy in the Philippines, which is the subject of this paper. Section II of the paper provides a brief overview of the different methods we use to estimate the combined incidence of taxes and expenditures in the Philippines. Section III presents our results. Section IV contains some concluding remarks. II. Methodology The analysis of tax incidence captures the effects of both direct and indirect taxes. Direct taxes include income and business taxes, while indirect taxes encompass excise, import tariffs, and value added taxes (VAT). The analysis of expenditure incidence captures three major categories that have significant distributional implications in the Philippines: infrastructure, health, and education. Tax Incidence Direct Taxes Since, like many developing countries, the Philippines has low collection rates, this paper considers the effective tax rate--tax revenue divided by the base--as opposed to statutory rates. Accordingly, the Bureau of Internal Revenue's (BIR) actual tax collections for 1988 and 1989 by gross income bracket form the basis for our tax incidence analysis. To map income classes into deciles, we use the 1988 Family Income and Expenditure Survey (FIES), which gives the number of families in each income class, albeit at a coarser degree of disaggregation than we use herein. Indirect Taxes We examine two effects of indirect taxes. The first is the "cascading," or interindustry, effect. For example, an excise tax on oil gets passed on to all users of oil, so that consumers of goods whose production uses oil end up paying part of the tax. The second indirect effect is the impact of a tax on the price of substitutes for the taxed good. For instance, an import tariff raises the price of import substitutes. Thus, consuners of the substitute good suffer a drop in their real income from the price increase, even 2 though they are not paying any of the original tax. For incidence analysis, these two effects of indirect taxes can be important and often dominate the effects of direct taxes. We incorporate both in our analysis by undertaking a general-equilibrium analysis of indirect taxation. It is noteworthy that the second type of indirect tax effect--the impact of a tax on the price of substitute goods--does not entail a payment by consumers to the government; rather, the payment will be the higher prices paid by consumers to producers of substitute goods. As a result, the incidence of a tax calculated with this method reflects both actual tax collections and the increased costs associated with each tax. Expenditure Incidence Here we focus on three expenditure categories that have significant distributional implications in the Philippines: infrastructure, health, and education. There are at least two distinct ways to measure the incidence of public expenditures (for a survey, see Selden and Wasylenko, 1991). One, known as "expenditure incidence studies," examines how government expenditures increase the income of different individuals in the economy (schoolteachers, doctors, construction workers, and so forth) and then determines where in the income distribution these people lie. The other approach, called "benefit incidence," considers the services provided by public expenditures--education, health care, infrastructure, etc. --and examines how different income classes, or deciles, use these services. This was the approach adopted in the pioneering studies of Meerman (1979) and Selowsky (1979). This paper adopts the benefit incidence approach as well. Given the dearth of data on the access of households to the public services supported by these expenditures, we apply an indirect method for obtaining the incidence of public spending: we look at the regional pattern of expenditures which, combined with information on income distribution within each region, yields inferences about the nationwide incidence pattern.' We use the 1988 FIES to apply income intervals corresponding to the national deciles to the population of each region, and thus obtain the percentage of households in each of the intervals. We then assume that the benefits from public expenditures in a region are distributed unifornly. In part, this assumption is justified by the idea that many infrastructure projects yield a public-good whose benefit is shared equally by everyone. 3 We use access data as indicators of the incidence of expenditures for education and health. For education expenditures, we use primary and secondary school enrollment rates; for health expenditures, we use hospital and clinic utilization rates. m. Results and Discussion Taxes Direct Taxes Income taxes. According to a recent study, the income tax collection rate in the Philippines is very low; only about 50 percent of potential income taxes are collected (World Bank 1992). Thus, while the statutory rates reflect a progressive tax, the effective rates may not. Table 1 shows the Bureau of Internal Revenue's estimate of actual tax collections for 1988 and 1989 by gross-income bracket. The effective tax rates (the ratio of tax payments to gross income) rise quite steeply with income. However, Table 1 breaks taxpayers down by income classes (or brackets) rather than by deciles. Quite simply, the number of households in each income class is by no means the same. Table 3 maps income classes into deciles based on FIES 1988, which gives the number of families in each income class. The resulting effective tax rates by decile are shown in columns 2 and 3 of Table 3. The apparent progressivity of the income tax is dampened when expressed in terms of deciles rather than income brackets. The reason for that effect is that the income classes that pay the highest tax rates (more than 10 percent) comprise only a small fraction of the Philippine population. They are averaged in with those who pay lower tax rates when we consider the highest decile of the population. The effective tax rates by decile can be compared with Manasan's (1990) estimates of the potential income tax rates by decile (Table 3, column 4). While the potential tax rates are significantly higher, the degree of progressivity is not much greater. In the Philippines, tax avoidance and evasion are evidently largely the province of the rich. Hence, if the government increased its efforts at tax collection, it would surely improve the income distribution in the country, as well as provide much needed revenue. 4 Table 1. Tax Collection by Gross-Income Categories (in pesos) 1 9fRR 19g9 No. of Effect No. of Tax- Gross Exemp- Taxable ive Tax- Gross Exemp- Taxable Tax due Effect Income bracket payers income tions income Tax due tax payers income tions income ive rate tax rate <2,000 6254 3229 109171 772 3256277 2-4,000 6304 19759 98356 5696 25366 4-6,000 10488 53750 163899 6236 38759 84384 6-8,000 13522 96405 208156 8-10,000 20215 185178 314371 4834 43979 63767 10-12,000 28120 314656 427063 12721 6672 74147 87753 3444 12-15,000 57858 790663 871423 102227 252 0 18088 248573 228047 46033 124 0.00 15-20,000 176658 3182259 2827056 694240 8182 0 55960 997771 720888 315053 3799 0.00 20-30,000 467742 11682920 6502209 5226095 174117 0.01 243338 6212767 3165338 3052704 105959 0.02 30-50,000 631727 23398588 9689531 13717110 745889 0.03 503884 19374077 7653536 11721181 663108 0.03 50-60,000 121143 6634433 1949900 4685558 366938 0.06 103172 5628882 1610709 4018292 316101 0.06 60-100,000 226617 17039643 3814455 13226838 1363581 0.08 199072 15166830 3361214 11805708 1227191 0.08 100-150,000 55348 6269432 932587 5336862 726944 0.12 70561 8499899 1208477 7291422 1038354 0.12 150-180,000 27319 3925195 470567 3454628 547069 0.14 17139 2803319 297025 2506294 424550 0.15 180-200,000 18454 3278093 321037 2957055 519161 0.16 7294 1382144 128455 1253689 225574 0.16 200-300,000 16235 3870904 280835 3590068 696432 0.18 15003 3559561 265840 3293721 637610 0.18 300-500,000 6681 2482116 112790 2369325 534610 0.22 5438 2015638 94192 1921445 433096 0.21 500-1,000,000 2710 1803318 44157 1759160 472679 0.26 1635 1022483 27308 995125 262016 0.26 >1,000,000 994 3394419 15731 3378688 1130033 0.33 253 992210 4246 987964 332422 0.34 Source: Bureau of Internal Revenue. 5 Table 2. Effective Tax Rates by Income Class (in pesos) 1 QR8 1 989_ Income Number of Average Gross Tax due Effective Average Gross Tax due Effective class families income income tax rate income income tax rate <6,000 179240 44625 7998585 0 0 49351 8845635 0 0 6-10,000 632703 8254 5222330 0 0 9128 5775375 0 0 10-15,000 14183339 12640 17927804 252 0 13979 19826359 124 0 15-20,000 1412363 17467 24669744 8182 0 19317 27282270 3799 0 20-30,000 2265258 24629 55791039 174117 0.003 27237 61699310 105959 0.002 30-40,000 1382995 34694 47981628 372944 0.008 38368 53062882 331554 0.006 40-60,000 1476584 48749 71981993 739882 0.010 53912 79604886 647655 0.008 60-100,000 1109936 75385 83672525 1363581 0.016 83368 92533445 1227191 0.013 > 100,000 656509 179092 1.2E+08 4626928 0.039 198058 1.3E+08 3353622 0.026 Source: FIES, Bureau of Internal Revenue. 6 Table 3. Effective Tax Rates by Decile (tax paid as a share of gross income) Decile 1989 1988 1987 Potential I 0.000 0.000 0.000 0.000 II 0.000 0.000 0.000 0.000 III 0.000 0.000 0.000 0.000 IV 0.001 0.002 0.000 0.000 V 0.002 0.003 0.003 0.000 VI 0.004 0.006 0.004 0.000 VII 0.008 0.010 0.006 0.002 VIII 0.008 0.010 0.009 0.006 IX 0.010 0.012 0.019 0.031 X 0.018 0.025 0.033 0.094 Source: Columnns 2 and 3: authors' calculations; column 4: Manasan (1990). Other estimates of income tax progressivity in the Philippines largely stratify the population by income class (Yoingco 1989 and Corcoran 1991). Not surprisingly, they reveal much higher effective tax rates for the top income bracket (around 7 percent), but for the reasons discussed earlier they are not directly comparable with the preceding estimates. Business taxes. The incidence of effective business tax rates is estimated in a manner analogous to income taxes. We use the FIES data to map the BIR's tax collections by income bracket into taxes paid by deciles (Table 4). We then compute the effective tax rates by decile (Table 5). Note that while the pattern of effective tax rates is quite progressive, the levels are extremely low. Even the richest 10 percent of the population pay less than two-tenths of 1 percent of their income in business taxes. There appears to be a fair amount of room for increasing business tax collections, which will in turn be equity-improving. 7 Table 4. Effective Tax Rates on Business Income by Income Class 1989 Income bracket Number of Gross Exemptions Taxable Tax due Effective taxpayers income income tax rate <2,000 155390 477 2958551 2-4,000 676 2126 12418 4-8,000 2154 13165 40074 8-10,000 1207 11258 23760 10-12,000 1383 15662 26395 313 12-15,000 1818 25059 35495 1102 3 0.00 15-20,000 3220 57396 63695 5596 60 0.00 20-30,000 7244 182901 117732 66025 1907 0.01 30-50,000 16406 644139 262479 381660 21448 0.03 50-60,000 4655 254345 72658 181686 14233 0.06 60-100,000 9853 765578 160718 604859 64212 0.08 100-150,000 4882 590693 80223 510460 73127 0.12 150-180,000 1421 233099 23007 210092 35750 0.15 180-200,000 658 124808 10805 114003 20566 0.16 200-300,000 1621 387737 26025 361712 70354 0.18 300-500,000 757 283504 12057 271447 61441 0.22 500-1,000,000 216 135615 3402 132213 34874 0.26 > 1,000,000 46 139358 655 138702 46115 0.33 8 Table 5. Incidence of Business Taxes Decile Effective Tax Rate I 0.0000 11 0.0000 III 0.0000 IV 0.0000 V 0.0000 VI 0.0001 VII 0.0003 VIII 0.0003 IX 0.0005 X 0.0016 Source: Authors' calculations. Indirect Taxes The Philippine government relies on indirect taxes for about 70 percent of its revenue. This fact alone explains why the tax system has been considered regressive. Since they are levied on transactions, indirect taxes can hurt the poor more than they do the rich, insofar as the former spend a larger fraction of their income than the latter. Furthermore, it is felt that some individual taxes in the Philippines--the excise tax on oil, for example--are particularly regressive because the poor spend a larger share of their income on them than do the rich. As pointed out earlier, we must examine the effects of each tax on prices to determine the incidence of indirect taxes in the Philippines. We do so by simulating the removal of each type of tax with a multisector, computable general equilibrium (CGE) model of the Philippine economy (Go 1991).2 The model solves for market-clearing prices and quantities that are consistent with the individual optimizing behavior of consumers and producers, a given set of world prices, and the policy environment. Four features of the model are worth bearing in mind when interpreting the results. First, the model captures the fact that, in the Philippines, 2 For an early attempt at using a CGE model for tax-incidence analysis, see Devarajan et al. (1981). Shah and Whalley (1992) note that general-equilibrium tax incidence studies of developing countries have been somewhat rare, although Habito (1984) and Mitra and Tendulkar (1987) are notable exceptions. 9 imports and domestic goods in the same sector are imperfect substitutes. Therefore, when a 10 percent tariff is removed, the domestic price of the substitute drops by less than 10 percent. The implication is that the effective tax rate paid by consumers of food, say, is somewhat less than the tariff rate on food. Second, the model includes interindustry ("cascading") transactions through the input-output table. Thus, an excise tax on oil, for example, ends up being a tax not just on final energy consumption, but also on other final goods that use oil at some stage in their production. This will have important implications for the burden of indirect taxation. Third, the tax rates that are used in the model are effective tax rates--that is, the actual revenue from a tax divided by its base. In this way, our calculations are consistent with those for direct taxes. Fourth, in simulating the removal of individual indirect taxes, we assume they are replaced by an income tax that preserves government revenue. Thus, we are examining the "true" price-distorting effects of the tax, rather than combining them with those generated by macroeconomic imbalances. In order to make the calculation of the indirect-tax burden comparable with that of direct taxes, we add to the burden induced by the price- distortions the proportional income tax required to preserve government revenue. Since the income tax is proportional, it does not distort the pattern of indirect-tax incidence. Having simulated the price effects of eliminating a particular tax, we examine how much of income each household income class spends on the different commodities (Table 6). The expenditure pattern is based on the FIES. When combined with the price changes, the pattern determines the change in purchasing power induced by each tax for each income class. This is the effective direct and indirect tax paid by the representative household. 10 Table 6. Household Expenditure Shares by Income Class Total <:6,000 6-10,000 10-15,000 15-20,000 20-30,000 30-40,000 40-60,000 60-100,000 > 100,000 Food 50.7 66.7 67.3 65.6 63.2 60.0 56.2 51.9 45.8 35.8 Alcohol 1.1 1.6 1.4 1.3 1.3 1.3 1.3 1.1 1.1 0.8 Tobacco 2.1 1.9 2.0 2.5 2.7 2.8 2.7 2.3 1.8 1.2 Fuel, light, water 5.2 7.9 6.9 6.4 6.1 5.6 5.2 5.1 5.0 4.7 Transportation- 4.7 2.1 2.3 2.6 2.8 3.2 3.5 4.1 4.7 7.9 Comunication Household 2.5 2.6 2.5 2.4 2.2 2.1 2.0 2.2 2.6 3.2 operations Personal care 3.3 1.8 2.3 2.7 3.0 3.2 3.4 3.5 3.5 3.3 Clothes, FTW 4.2 2.5 3.2 3.8 4.1 4.4 4.5 4.5 4.4 3.9 Education 2.9 0.5 0.8 1.0 1.4 1.6 2.2 3.0 4.0 4.1 Recreation 0.5 0.1 0.1 0.2 0.3 0.3 0.3 0.4 0.5 0.8 Medical 1.7 1.6 1.2 1.3 1.5 1.4 1.7 1.7 1.8 1.9 Nondurable 0.4 0.1 0.2 0.3 0.3 0.4 0.4 0.4 0.4 0.4 furniture Durable 1.8 0.1 0.1 0.2 0.3 0.8 1.6 1.9 2.6 2.9 furniture Rent 11.7 8.0 6.8 6.5 6.6 7.9 9.0 11.0 13 18.2 Maintenance 1.1 0.7 0.7 0.9 1.0 1.1 1.0 1.2 1.3 1.1 Taxes 1.1 0.1 0.1 0.2 0.2 0.2 0.3 0.5 1.0 3.1 Miscellaneous 3.3 1.3 1.6 1.9 2.5 2.7 3.3 3.3 3.7 4.1 Other 1.8 0.3 0.3 0.5 0.6 0.8 1.3 1.8 2.6 2.8 Total 100.1 99.9 99.8 100.3 100.1 99.8 99.9 99.9 99.8 100.2 Source: FIES 11 Excise taxes. The first part of Table 7 presents the initial effective rates ("partial equilibrium") and the model-simulated rates ("general equilibrium") of the excise tax in the Philippines. The partial effects reflect the commonly accepted incidence pattern. Excise taxes of this nature are generally regressive, although other studies have found that the recent adaptations in the petroleum product tax rates have been sufficient to make the direct effect of these taxes progressive (Yoingco 1992). The general-equilibrium rate for utilities (fuel, electricity, and water) is three times higher than the partial-equilibrium one--due to the cascading effect mentioned earlier. Furthermore, while the excise tax is levied directly only on a few sectors, the general- equilibrium simulation reveals that the price of all sectors is affected by the tax. Again, this is due to the interindustry transactions captured by the model. When these price changes are mapped into expenditure shares, the resulting burden is mildly progressive when the tax is computed as a percentage of expenditures (Table 7, bottom panel). The reason is that even though the poor spend a larger fraction of their income on utilities than do the rich, even an excise tax on oil ends up raising the prices for almost all goods, including those (primarily services) consumed intensively by the rich. The net effect of the excise tax reveals a burden that rises with income. If these effective excise tax rates are compared with measured income, then the pattern is mildly regressive--but only because the poor consume a larger fraction of their income than do the rich. Also at issue is whether the data on expenditures are more reliable than those on income (both are from the FIES). There is some reason to believe that expenditure data are underreported in the FIES, and more so for the upper income brackets. In this case, the regressivity picked up in the last column of Table 7 would be dampened. Furthermore, expenditures may be a better proxy for permanent income, which should be the base for incidence calculations anyway. However, given that we used income as a base to calculate the burden of income taxes, we continue using the same base to calculate the incidence of indirect taxes, thus permitting aggregation across taxes. 12 Table 7. Excise Tax Rate Effective Excise Tax Rates Partial equilibrium General equilibrium Food 0 0.004 Alcohol 0.034 0.05 Tobacco 0.034 0.05 Fuel, light, water 0.025 0.0784 Transportation & 0 0.04 Communication Household OPS 0 0.018 Personal care 0 0.018 Clothing and footwear 0.034 0.05 Education 0 0.018 Recreation 0 0.018 Medical 0 0.018 Nondurable furniture 0.034 0.05 Durable furniture 0.012 0.03 Rent 0 0.018 Maintenance 0 0.025 Table 7. Excise Tax Rate (continued) Effective Excise Tax Rates by Decile Decile Tax as % of expenditure Mean expenditure Mean income Tax as % of income I 0.050 8904 8581 0.052 II ~~~~0.051 12913 12866 0.052 III ~~~~0.053 15858 16398 0.051 IV 0.054 18793 20179 0.051 V 0.056 22104 24329 0.050 VI 0.057 26172 29460 0.050 VII 0.058 31616 36482 0.050 Vill 0.060 39056 46774 0.050 IX 0.061 52209 64607 0.050 X 0.071 97580 144805 0.048 13 Import tariffs. As with excise taxes, and for the reasons cited earlier, the partial- and general- equilibrium import tariff rates diverge quite markedly (Table 8). On the one hand, the effective tariff rate on utilities doubles when general-equilibrium effects are incorporated, because the utility sector contains both oil (a tradable) and water and electricity (nontradables). Thus, the direct tariff payments of this sector are relatively small. Yet, even the nontradable parts of this sector consume oil, so that the cascading effect of the oil tariff is quite large. On the other hand, the effective general-equilibrium tariff on clothing and footwear is about one-third its partial-equilibrium value, given the imperfect substitutability between imported and domestic clothes and shoes in the Philippines. The net result is an incidence pattern that is neutral when taken as a fraction of expenditures, and regressive as a fraction of income--the latter for the reason mentioned earlier. Table 8. Import Tariff Rates Effective huport Tariff Rates Partial equilibrium General equilibrium Food 0.126 0.073 Alcohol 0.295 0.109 Tobacco 0.295 0.109 Fuel, light, water 0.0476 0.0952 Transportation/ 0 0.092 Communication Household OPS 0 0.084 Personal care 0 0.084 Clothing and footwear 0.295 0.109 Education 0 0.084 Recreation 0 0.084 Medical 0 0.084 Nondurable furniture 0.295 0.109 Durable furniture 0.146 0.1 Rent 0 0.084 Maintenance 0 0.095 14 Table 8. Import Tariff Rates (continued) Effective Import Tariff Rates by Decile Decile Tax as % of expenditure Tax as % of income I 0.115 0.119 II 0.116 0.116 III 0.117 0.113 IV 0.118 0.110 V 0.119 0.108 VI 0.120 0.107 Vll 0.121 0.105 Vlll 0.122 0.102 ix 0.124 0.100 X 0.132 0.089 Table 9. Value Added Taxes Effective VAT Rates Partial equilibrium General equilibrium Food 0 0.013 Alcohol 0.039 0.033 Tobacco 0.039 0.033 Fuel, light, water 0 0.0086 Transportation/ 0 0.017 Conmnunication Household OPS 0 0.015 Personal care 0 0.015 Clothing and footwear 0.039 0.033 Education 0 0.015 Recreation 0 0.015 Medical 0 0.015 Nondurable furniture 0.039 0.033 Durable furniture 0.039 0.029 Rent 0 0.015 Maintenance 0.039 0.04 15 Table 9. Value Added Taxes (continued) Effective VAT Rates by Decile Decile Tax as % of expenditure Tax as % of income 1 0.037 0.038 II 0.037 0.037 III 0.038 0.037 IV 0.040 0.037 V 0.040 0.036 VI 0.041 0.036 VII 0.042 0.036 VIII 0.042 0.035 IX 0.043 0.035 X 0.049 0.033 Value added tax. Although the value added tax (VAT) in the Philippines is based on the rebate method, data on the rebates paid out are unavailable. Therefore, the VAT is simulated here as a tax on the fuial consumption of the commodities (primarily consumer goods). The result is a dilution of the tax rate when its effects on prices are simulated (Table 9, panel 1). The incidence effects of this tax are practically neutral, except when the income-expenditure differential across deciles is taken into account. In this case, the tax is regressive, but not greatly so. In sum, we find that the overall burden of indirect taxes in the Philippines falls more or less equally on the poor and the rich. This is true for total indirect taxes and for each of the components. The net result of the analysis of import tariffs and the VAT is an incidence pattern that is neutral when taken as a fraction of expenditures, and regressive as a fraction of income--the latter for the statistical reasons mentioned earlier. This finding is in sharp contrast to earlier estimates of the indirect-tax burden in the country (see, for example, World Bank, 1986) which concluded that the system was quite regressive. However, these earlier analyses did not examine the general equilibrium effects of indirect taxes. In fact, our results dispute some recent work on tax incidence in the Philippines (Corcoran 1991 and Manasan 1991) which, while conceding that the system is less regressive than in the past, still point to the regressive 16 nature of indirect taxes. Again, neither of these studies examines general-equilibrium effects which, as we showed, play a crucial role in dampening the regressivity of indirect taxes in the Philippines. Consolidation Table 10 presents the consolidated tax burden in the Philippines. Overall, the system is largely neutral, with all deciles effectively paying about 10 percent of their income in taxes. On the one hand, based on reported incomes by decile, the slightly regressive nature of the indirect taxes is sufficient to render the overall system mildly regressive, despite the progressive nature of direct taxes. The primary reason for its regressivity is the overwhelming inportance of indirect taxes in the Philippine economy. But the difference in the tax rate paid by the highest and by the lowest deciles is just more than 1 percentage point. On the other hand, most of the regressivity in indirect taxes stems from the statistical divergence between expenditures and income that varies implausibly across deciles. Thus, if in defining tax incidence we used expenditures rather than income as our base for calculating burden, the indirect-tax pattern would be almost neutral, rendering the overall system progressive (Table 10, bottom panel). Table 10. Distribution of Tax Burden Income-Based Decile Income Business Excise Tariffs VAT Total I 0 0 0.052 0.119 0.038 0.208 11 0 0 0.052 0.116 0.037 0.205 III 0 0 0.051 0.113 0.037 0.201 IV 0.002 0 0.051 0.110 0.037 0.200 V 0.003 0 0.050 0.108 0.036 0.198 VI 0.006 0 0.050 0.107 0.036 0.199 VII 0.010 0 0.050 0.105 0.036 0.201 Vill 0.010 0 0.050 0.102 0.035 0.197 IX 0.012 0.001 0.050 0.100 0.035 0.197 X 0.025 0.002 0.048 0.089 0.033 0.196 17 Table 10. Distribution of Tax Burden Expenditure-Based Decile Income Business Excise Tariffs VAT Total I 0 0 0.050 0.115 0.037 0.200 II 0 0 0.051 0.116 0.037 0.204 III 0 0 0.053 0.117 0.038 0.208 IV 0.002 0 0.054 0.118 0.040 0.215 V 0.003 0 0.056 0.119 0.040 0.218 VI 0.007 0 0.057 0.120 0.041 0.224 VII 0.012 0 0.058 0.121 0.042 0.232 VIII 0.012 0 0.060 0.122 0.042 0.236 IX 0.015 0.001 0.061 0.124 0.043 0.244 X 0.037 0.002 0.071 0.132 0.049 0.291 Public Expenditures We now turn to the expenditure side of the ledger. As stated in the introduction, we focus on three components of the budget that have strong distributional effects: health, education, and infrastructure. Together, these account for about 30 percent of government expenditures, or 6 percent of GDP. In a country such as the Philippines, where health and education are provided overwhelmingly by the private sector, public expenditures in these two sectors will be targeted particularly at alleviating poverty. Moreover, while infrastructure expenditures are typically meant to release supply bottlenecks, they could have important distributional consequences in the Philippines, where the rural infrastructure is particularly weak, and where the majority of the poor live in rural areas. Returning to the general case in which we use regional expenditure data to derive benefit incidence, we can infer for each expenditure category the implicit subsidy (expenditures per household as a fraction of average household income) that is associated with each of the 10 nationwide deciles in each region. The overall incidence of public expenditures in health, education, and infrastructure is a weighted average of the regional incidence, the weights being the regional allocations of these expenditures. 18 Table 11. Public Expenditures by Region (in thousands of 1988 pesos) Region Health Education Infrastructure NCR 148063 1685286 4093987 I 321047 686088 611187 II 215251 1251118 977986 III 402220 1818392 1214689 IV 603226 1079836 1791055 V 339864 1525578 885829 VI 339559 921344 783604 VII 319439 922158 668269 VIII 315742 736527 899791 IX 228044 765839 310566 X 285925 814766 629805 xi 278104 719522 673637 XII 178975 28712 303910 CAR 221947 191455 341923 Source: Budget Division, FMS. Table 12 shows the incidence pattern across deciles as implied by this method of allocating public expenditures. The picture is clear: public expenditures have a beneficial effect on the distribution of income. Indeed, the pattern is strongly progressive, with the lowest decile receiving almost half of their income in benefits, and with the top 10 percent receiving virtually nothing. Of course, it should be noted that this result stems directly from our assumption that the benefits from expenditures in any region accrue uniformly throughout that region. It follows that the benefits would comprise a much higher fraction of the income of the lowest decile than of the highest decile. However, another reason is that public expenditures appear to be concentrated in regions that have a large share of the nation's poor. For example, in Region V (Bicol), some of the highest shares of its population fall in the nation's lowest decile, yet the region receives the third highest amount of expenditures on education and the fourth highest on infrastructure. Similarly, another region with a concentration of the nation's poor, Region IV (Southern Tagalog), receives the sixth highest amount of educational expenditures and the second highest infrastructural expenditure. Meanwhile, the National Capital 19 Region, which has the largest share of its population in the top decile, receives a large absolute amount of infrastructure and other spending, but, because it is also the most populous, has among the lowest per capita spending. Table 12. Incidence of Public Expenditures (benefits as a share of gross income) Decile Health Education Infrastructure I 0.073 0.209 0.187 II 0.035 0.1 0.087 III 0.028 0.078 0.069 IV 0.023 0.062 0.059 V 0.02 0.051 0.051 VI 0.017 0.041 0.044 VII 0.015 0.034 0.038 VIII 0.012 0.025 0.032 IX 0.009 0.018 0.024 X 0.0002 0.0004 0.0005 Source: Authors' calculations. As mentioned earlier, these calculations make no allowance for differences in utilization rates of these public services across income groups. Yet there is some evidence that in the Philippines the poor use educational services less (on a proportional basis) than do the rich (World Bank 1986). We now examine how this information modifies the incidence pattern derived above. (The only source of data on utilization rates by deciles is the 1982-83 Household and School Matching Survey, which lists enrollment rates by different age and income groups, as shown in Table 13). We combine these utilization data with data on total (that is, current and capital) expenditures on primary and secondary education to estimate the extent to which considerations of utilization rates modify our conclusions about the incidence of expenditures. The regional pattern of expenditures on primary and secondary education is provided in Table 14. 20 Table 13. Enrollment Rates by Age and Income Decile Decile Ages 7-10 Ages 11-12 Ages 13-14 Ages 15-16 Total I 0.971 0.905 0.663 0.537 0.774 II 0.951 0.890 0.704 0.496 0.758 III 0.960 0.892 0.697 0.506 0.767 IV 0.978 0.933 0.771 0.603 0.822 V 0.984 0.945 0.881 0.646 0.866 VI 0.974 0.939 0.851 0.701 0.868 VII 0.990 0.938 0.833 0.727 0.875 VIII 0.990 0.968 0.885 0.693 0.886 IX 0.990 0.981 0.939 0.802 0.926 X 0.994 0.963 0.894 0.864 0.928 Source: World Bank, 1986.3 Table 14. Public Expenditures on Education, 1990 (in millions of 1990 pesos) Region Elementary Secondary NCR 1323.9 933.4 I 807.6 465.7 II 492.8 341.7 III 1118.4 494.1 IV 1709.5 620.9 v 944.2 390.5 VI 1192.5 808.0 VII 930.4 208.1 VIII 762.2 391.0 IX 706.7 216.4 X 786.9 283.9 XI 834.0 264.6 XII 737.4 208.7 CAR 283.0 165.7 Source: Budget Division, FMS. The original table reported enrollment rates by urban and rural deciles. The table here is a weighted average of those rates, based on weights from the 1988 FIES. 21 The regional distribution alone implies a particular incidence pattern for the benefits of public expenditures on primary and secondary education. This pattern, which is calculated on the basis of the regional income distribution data provided in Table 12, is provided in column 2 of Table 15. The next two columns show how this structure changes when utilization rates are taken into account. The first of the two columns combines the utilization rates in Table 13 for primary and secondary education. The second is derived from the fact that the decile-specific utilization rates differ between primary and secondary education-- in particular, the lower utilization rates among poorer people is much more pronounced in secondary education than in primary. Table 15. Benefit Incidence Based on Utilization Rates (as a share of gross income) No Adjustment Adjustment based on Adjustment based on different Decile average utilization rates primary/secondary utilization rates I .325 .252 .289 II .139 .105 .121 III .109 .083 .096 IV .089 .073 .081 V .072 .063 .068 VI .059 .052 .055 VII .047 .041 .044 VIII .036 .032 .034 IX .026 .024 .025 X .0005 .0005 .0005 Source: Autior's calculations. Not surprisingly, the incorporation of utilization rates dampens the progressive nature of educational benefits. However, the pattern is still strongly pro-poor, with the lowest decile receiving about a quarter of their income in benefits, and with the highest receiving nothing. Furthermore, insofar as primary expenditures 22 are the major redistributive element, and since primary utilization rates are more or less uniform across deciles, the resulting pattern is only slightly modified in the absence of utilization rates. It is instructive to compare our estimates of the distribution of education and health expenditures in the Philippines with those obtained by van de Walle (1992) for the same two sectors in Indonesia. Indonesia's per capita income and stage of economic development are roughly similar to those of the Philippines; both are archipelagic nations; and the two countries have often been listed together as among the next generation of potential East Asian "tigers." Unlike our study, however, van de Walle's benefit incidence analysis draws heavily on access to public services and utilization rates. Hence, the two measures are not equivalent, but van de Walle' s estimates come closest to providing us with an international comparison. Table 16. Incidence of Educational and Health Expenditures in Indonesia (as a percent of per capita household expenditures) Decile Education Health 1 .19 .007 II .16 .007 III .14 .005 IV .13 .006 V .07 .006 VI .07 .006 VII .06 .007 Viii .05 .006 IX .04 .005 X .03 .003 Source: van de Walle (1992). The distribution of educational benefits in Indonesia closely mirrors the progressive pattern found in the Philippines. The incidence of health benefits is somewhat less progressive than in the Philippines, although health expenditures in the Philippines, too, are distributed more neutrally than are educational expenditures 23 (see Table 12). Van de Walle attributes the lack of progressivity in health expenditures in Indonesia to poor targeting--something that could be discerned only with data on access to public services by different income groups. To the extent that targeting may also be poor in the Philippines, our conclusion about progressive health expenditures should be qualified. IV. Conclusions In Table 17, we present the combined incidence of taxes and public expenditures in the Philippines. While this is nothing more than a consolidation of Tables 10 and 12, it tells a somewhat surprising story. The incidence pattern of taxes is basically neutral; it is the pattern of expenditures that drives the combined incidence, which is progressive. Table 17. Net Incidence of Taxes and Public Expenditures Income-Based Decile Taxes Expenditures Net Incidence I 0.208 0.469 -0.261 II 0.205 0.222 -0.017 m 0.201 0.175 0.026 IV 0.200 0.144 0.056 V 0.198 0.122 0.076 VI 0.199 0.102 0.097 VII 0.201 0.087 0.114 vm 0.197 0.069 0.128 IX 0.197 0.051 0.146 X 0.196 0.0011 0.195 While we made numerous assumptions in reaching this conclusion, it is hard to imagine that a further refinement of the data would reverse the pattern discerned here. The neutrality of taxes stems from the fact that indirect taxes are only slightly regressive, something that cuts against the grain of previous studies of the 24 Philippines and elsewhere. The reason for this result is the simple but little-noted fact that while the poor consume taxed goods (like energy) directly, the rich consume them indirectly through their purchases of goods that require energy and other taxed goods in their production. Our assumptions were particularly heroic on the expenditure side, where we used the regional distribution of public spending to infer the incidence of benefits. This was necessitated by our lack of data on access to public services by income groups. However, in one case for which we had such data--primary and secondary education--the incorporation of utilization rates into the analysis dampens the progressivity of expenditures, but only slightly. References Ahrnad, Etisham, and Nicholas Stern. 1989. Tax Reform and Development: An Economic Analysis of the Indian Fiscal System, Cambridge: Cambridge University Press. Corcoran, C. B. 1991. "Tax Burden by Income Class in the Philippines," Center for Research and Communication. Devarajan, Shartayanan, Don Fullerton and Richard A. Musgrave. 1980. "Estimating the Distribution of Tax Burdens: A Comparison of Different Approaches," Joumal of Public Economics, 13: 155-82. Habito, Cielito. 1984. "Equity and Efficiency Tradeoffs in Philippine Tax Policy Analysis: A General Equilibrium Approach," Ph. D. Thesis, Harvard University. Manasan, Rosario. 1990. "An Assessment of Fiscal Policy in the Philippines," Philippines Institute of Development Studies, Working Paper No. 9006. Meernan, Jacob. 1979. Public Spending in Malaysia: Who Benefits and Why, New York: Oxford University Press. Mitra, Pradeep, and Suresh Tendulkar. 1993. "Coping with Exogenous Internal and External Shocks: India, 1973-74 to 1983-84," in Pradeep Mitra and Associates, Adjustment to Oil Shocks in Developing Countries, Carnbridge: Cambridge University Press. Selden, Thomas, and Michael Wasylenko. 1995. "Benefit Incidence Analysis in Developing Countries," in Dominique van de Walle and Kimberly Nead, eds., Public Spending and the Poor, Baltimore: Johns Hopkins Press. Selowsky, Marcelo. 1979. Who Benefits from Government Expenditures? A Case Study of Colombia, New York: Oxford University Press. 25 Shah, Anwar, and John Whalley. 1991. "Tax Incidence Analysis of Developing Countries," World Bank Economic Review, 5: 535-52. van de Walle, Dominique. 1995. "The Distribution of the Benefits from Social Services in Indonesia, 1978- 87," in Dominique van de Walle and Kimberly Nead, eds., Public Spending and the Poor, Baltimore: Johns Hopkins Press. World Bank. 1988. "The Philippines: The Challenge of Poverty," Report No. 7144-PH. World Bank. 1992. "The Philippines: Domestic Resource Mobilization and Management," Report No. 10056-PH. Yoingco, Angel Q. 1989. "A Study of the Burden of Philippine Taxes," Philippine National Science Society. Yoingco, Angel Q. 1992. "A Study on the Incidence of the Fiscal System," mimeo, National Economic Development Authority. 26 Policy Research Working Paper Series Contact Title Author Date for paper WPS1517 Inflation Crises and Long-Run Michael Bruno September 1995 R. 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